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Chapter 2 – Adjustments and Itemized Deductions

Adjustments (Deductions) to Gross Income to arrive at AGI – Above the line deductions

Educator Expenses
- Deduct up to $250 of qualified expenses paid (or $500 for married, both are educators)
- Eligible: KG to 12 grade teacher, instructor, counsellor, principal, or aide in school for at least 900 hours a year
- Reduce qualified expense amounts by:
o US series EE and I savings bond interest, non-taxable state tuition, non-taxable Coverdell Savings

Traditional Deductable IRA


- Contribution = deductible in the year contributed
- Earnings = tax deferred
- Distributions/Withdrawals = taxable contribution and earnings
- Cannot deduct contribution if BOTH of the following are present:
o Excessive AGI 2008: S/HofH – 53-63,000 MFJ: 85-105,000
o Active participation in another qualified plan
- No deduction if: Rich and Have retirement plan
o Exception: if one spouse isn’t is not active participant, then that spouse can still deduct contributions
o Phase-out: if only one spouse actively contributes, then second spouse phase-out limit for contribution is
MAGI: 159-169,000
- Amount of deduction: LESSER of: $5,000 or individual’s compensation (His + Hers = Theirs)
- Maximum contribution for MFJ total deductable contribution: $10,000
- Compensation: salary, commissions, alimony (not incl. PALs and pension)
- Catch-up contribution: Age 50 or over = contribution extra $1,000
- Retirement plan contribution credit ???
- MUST See chart on page R2-7

Roth IRA
- Contributions = non-deductible
- Earnings = tax-free
- Distributions/Withdrawals = tax-free contribution and earnings
- Contribution limits – combined with all IRAs = $5000/person
- Phase-out: S MAGI: 101-116,000 MFJ MAGI: 159-169,000 MFS MAGI: 0-10,000
- Retirement plan contribution credit ???

Non-Deductible IRA
- Contributions = non-deductible
- Earnings = taxable
- Distributions/Withdrawals = tax-free contributions and taxable earnings
- Contribution limitations: - LESSER of: $5,000 or individual’s compensation

Coverdell Education Savings Accounts (Education IRA)


- Contributions = non-deductible, maximum limit $2,000 annually
- Earnings = tax-free
- Distributions/Withdrawals = tax-free contributions and earnings if used for qualified education expense (includes
elementary and secondary school expenses)
- Beneficiary must use by age 30, otherwise:
o Distribute to beneficiary = taxable and 10% penalty
o Rollover to family member = tax-free and no penalty
- Designated beneficiary must be under age 19
- Maximum contribution per beneficiary is $2,000 annually
- Phase-out for MAGI – S:95-110,000 M:190-220,000

MUST SEE chart on page R2-10 – it includes the IRA Contribution and Withdrawal Summary

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Student Loan Interest Expense
- Limited to $2,500 interest expense per year
- Phase-out – S: 55-70,000 M: 115-145,000 (married, must file jointly to claim), dependent may NOT claim
- Taxpayer must be obligated to pay loan (interest paid by parent on child’s student loan is not deductible)

Tuition and Fees Deduction

- Qualified higher education expenses above the line deduction applied regardless of whether the education was
work-related expired on December 31, 2007.
- Prior: expenses were only deductible as education expenses – itemized deductions subject to 2% AGI limitation
- Maximum deduction: $4,000
- Maximum Income limit – Phase-out – S: 65,000 M: 130,000
- Over the phase-out limit, the maximum adjustment is $2,000
- No adjustment if AGI in excess of S: 80,000 M: 160,000

Health Savings Accounts


- HSAs = if high-deductible health insurance, then make pre-tax contributions of $2900 in 2008 ($5800 for families)
- High-deductible = $1,100 individual deductible and $2,200 family deductible

Moving Expenses
- Must be work related
- New workplace must be 50 miles FARTHER from old house than old workplace was
- Must work at new job for at least 39 weeks or 75% of the year
- Only direct moving costs are allowable for deduction:
o Travel and lodging of the taxpayer and his family (gas mileage, tolls, parking fees)
o Household goods and personal items from old to new house
- NON-deductible: Indirect costs = meals, house hunting, expense of breaking lease, temporary living expenses

Tax on Self-Employment (Social Security 50%)  the boss’ half of social security and Medicare tax is deductible

Self-Employment Health Insurance (100% Deductible)


- For self-employed individuals only!
- For employed individuals, it is an itemized deduction subject to the AGI % floor limitation

Keogh Profit Sharing Plans –


- Who qualifies? A self-employed taxpayer subject to self-employment tax
- Maximum annual deductible limited to LESSER of: 46,000 in 2008 OR 25% net (Keogh/self-employed) earnings
- Maximum annual addition may exceed the deductible amount, limited to LESSER or: 46,000 in 2008 OR 100%
net earnings (only if compensation is less than $46,000)
- Net earnings from self-employment (after Keogh deduction and on-half of self-employment tax)

Business Income
<Business Expense>
Net Business Income
<½ self employment tax>
<Keogh deduction>
Keogh net earnings
- 25% of self-employment after Keogh deductions is the mathematical equivalent of 20% (25%/125%) of self-
employment income before the Keogh deduction

Penalty on Early Withdrawal of Savings (Interest Income): Interest Forfeited


- The interest forfeited is deductible if it was shown as an income in the prior year

Alimony
- Alimony-spousal support = income to payee and deduction to payor
o Payments must be legally required under a written divorce decree or agreement

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o Payments must be in cash or equivalent
o Payments cannot extend beyond the death of the payee-spouse
o Cannot be made to members of same household, not be designated as anything other than alimony
o Spouses may NOT file joint tax return
- Child support = non-taxable to payee and non-deductible to payor
o Payment applies first to child support
- Property settlements = non-taxable/non-deductible to either parties  “HIDE IT”
o Applies to the lump sum payment or property divorce settlement

Attorney Fees Paid in Discrimination Cases

- Applicable only in certain cases in connection with age, sex, or racial discrimination
- Deductible amount is limited to amount claimed as income from the judgement

Domestic Production Activities


- Adjustment for a percentage (6% in 2007) of qualified production activities income or taxpayer’s taxable income
without considering the deduction  whichever is LESS

Deductions from Adjusted Gross Income (AGI) – Below the line deductions
- Standard deduction OR
- Itemized deduction

Standard Deduction  1040EZ


- Non-itemize
- Single 5,450 / HofH: 8,000/ MFJ: 10,900 / MFS: 5,450–same as S. Available only if BOTH spouses do not itemize
- Elderly and/or Blind = Increased standard deduction (NOT additional exemption)

Itemized Deductions –

Limitations
- Limitation applies to itemized deductions of taxpayers with AGI exceeding $159,950
- Limitation reduces, but not by more than 80%, applicable itemized deductions (taxes, interest, contributions, and
misc. Itemized deductions) by 3% of amount of AGI exceeding $159,950.
- Itemized deductions NOT subject to limitation:
o G – Gambling losses
o I – Investment interest expense
o M – Medical expenses
o C – Casualty and theft losses (non-business)

Medical Expenses = 7.5% AGI


- Payments for yourself, spouse, or dependent
- For dependent, there is no consideration of dependent’s gross income or joint return requirement. But all other
dependency tests still apply – Dependent test:
o Support over 50% = Yes
o Under $ taxable income = No  Waived
o Precluded joint return = No  Waived
o Only citizens = Yes
o Relative (OR) = Yes
o Taxpayer lives with = Yes
- Must be paid (cash or check) or charged on credit card during the year
- Deductible expenses: prescription medicine, doctors, medical and accident insurance, required surgery,
transportation to medical facility, physically handicapped costs (i.e. removal of structural barriers at home)

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- Non-deductible expenses: elective surgery, elective cosmetic operations, life insurance, capital expenditures (up
to the increase in FMV of the property because of the expenditure), health club memberships, personal hygiene

State, local, and foreign taxes (not Federal taxes)

Real Estate Taxes:


- Taxpayer must be legally obligated to pay in order to deduct the taxes
- Prorate taxes in year of sale/purchase
- Taxes paid under protest are deductible. Subsequent recovery is included in gross income
- Real estate taxes do not include street, sewer, and sidewalk assessment taxes

Income Taxes:
- Estimated taxes paid during the year are deductible
- Withheld taxes from paychecks during the year are deductible
- Assessments paid during the year for prior year’s tax are deductible
- Refunds are gross income (if deducted in prior year) and should not be netted against the itemized tax deduction

Personal Property Taxes

Sales Tax:
- May elect to deduct either state and local income taxes or state and local general sales taxes.
- If sales tax is chosen, then the amount is either:
o Total of actual general sales taxes paid OR
o IRS table, plus any amount of sales tax paid for a motor vehicle, boat, or other IRS approved items
Non-deductible Taxes:
- F – Federal taxes (included Social Security)
- I – Inheritance taxes for states (aka federal estate pick-up tax)
- B – Business (on Schedule C) and rental property taxes (on Schedule E)

***Cash basis taxpayers are entitled to a deduction in year an item is paid or charged. Note, that there is no “matching” to
the year the tax is applicable***

Interest Expense: HIPPE


st nd
H – Home Mortgage Interest = 1 and 2 home
- Acquisition indebtedness = $1,000,000 Maximum = interest on up to $1mil acquisition indebtedness is deductible
st nd
o Incurred in buying, constructing, or substantially improving taxpayers 1 or 2 home
- Home Equity Indebtedness = $100,000 Maximum = $$$ used for anything  Maximum deductible is LESSER of:
o $100,000 OR
o FMV of property reduced by the amount of outstanding acquisition indebtedness
- Mortgage Insurance Premiums paid in connection with qualified acquisition debt are deductible as mortgage
interest (phase-outs apply)
I – Investment Interest Expense = treated like gambling loss rules
- Deduction limited to net taxable investment income
- Any dividend income, from stock purchased with borrowed funds, which the taxpayer treats as investment income
for purposes of the limitation on investment expense is NOT a qualified dividend, available for 15% tax rate
- Excluded from investment taxable income  interest expense used to purchase tax-free bonds is not deductible
because the interest earned on the bonds is not taxable
- Investment expenses (i.e. advice fees, safe deposit rentals) other than interest are deductible on Schedule A as
misc. Itemized deductions (subject to 2% AGI)
- Excess can carry-forward indefinitely

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P – Personal (Consumer) Interest is Not Deductible

P – Prepaid Interest (allocate to proper period)


- Deduct when incurred AND paid
- Applies to accrual basis AND cash basis

E – Educational Loan Interest = It is an adjustment, NOT an itemized deduction

Charitable Contributions = 30% or 50% AGI


- Charity: items given to organizations = tax deductible
- Gifts: items given to individuals (needy families) = non deductible
- Political contributions: items given to candidates = non deductible
o Cash: 50% of AGI
o General property: lesser of basis or FMV
o Long-term appreciated property: lesser of 30% of AGI or remaining amount to reach 50% after cash
o Property to public charity: 30% of AGI
o Property to private charity: 20% of AGI
- Contributed property deduction = lesser of the property's basis or its FMV
- Appreciated property: FMV is greater than basis, and held over 1 year = deduct at FMV
- Taxpayer may deduct the excess contribution over the consideration received
o Example: buy ticket to charity dinner for $200, value of ticket $50, so can take $150 charitable deduction
- Deduction allowed only in year contributed by cash, check, or card charged
- Not deduct the value of time or services donated
- If taxpayer takes in foreign student, then deduct $50 per month for each full month (15 days or more)
- Excess contribution can carry-forward for 5 years

Casualty and Theft Loss = 10% AGI


- Loss = different between market value of property before and after the casualty
- May not exceed the basis of property
Smaller loss (1. Cost basis or FMV)
<Insurance recovery>
Taxpayer’s loss
<$100> IRS Deductible
Eligible loss
<10% AGI>
Deductible loss
- Must be sudden or unexpected
- Loss for non-business property cannot be deducted UNLESS insurance claim filed or not covered by insurance
- No deduction for lost, misplaced, or broken property

Miscellaneous Itemized Deductions = 2% AGI


- Unreimbursed business expense = Employee (self-employed expenses go on Schedule C)
o Meals and lodging = must be overnight business travel
o Transportation expenses 100% deductible for out-of-town and local travel (except ordinary commuting
expenses)
o Meals and entertainment expense = 50% deductible
o No deduction of club dues
- Education expenses (those not deducted above AGI, if adjustment is extended into 2008)
o Deductible expense if:
 Maintain or improve the skills needed by individual in his business
 Meet the express requirements for retention of job
 Must be job-related
o Not deductible if it were to meet minimum job requirements or qualified him for a new business
- Uniforms – purchase, cleaning, and repair
- Business gifts - $25 per recipient per year for business gifts
- Business use of home only deductible if exclusively used for work purposes

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- Employment agency fees are deductible for a new job in same profession, not for first job or new profession
- Investor expenses – investment advice/newsletters, safe deposit box rentals
- Subscriptions to professional journals
- Tax preparation fees (not related to divorce)
- Activities not engaged for profit = hobbies are deductible
- No deduction to activity not engaged for profit, EXCEPT the following are allowed for for-profit activities:
o Interest and taxes are allowed
o Loss are allowed to be deducted equal to income, but no losses are allowed
o If 3 out of last 5 taxable years show profit = activity is automatically for profit
 In rare cases it’s 2 out of 7 years (i.e. breeding, training, racing of horses)

Other Miscellaneous Deductions = NO 2% AGI


- Gambling losses = fully deductible only to the extent of gambling winnings
- Federal estate tax paid on income in respect of a deceased person

Tax Calculations and Credits

A reduced tax rate of 15% or 0% (for taxpayers in 15% or 10% tax bracket) is provided for:
• Qualified dividends
• Long-term capital gains

Personal Tax Credits:


 May reduce personal tax liability to zero, but not result in a cash refund
 Includes:
o Child care credit
o Elderly and permanently disabled credit
o Education credits: Lifetime Learning credit and Hope Scholarship credit
o Adoption credit
o Retirement savings contribution credit
o Foreign tax credit
o General business credit

Refundable Credits:
 Subtracted from income tax liability and may result in a cash refund
 Includes:
o Child tax credit
o Earned income credit
o Withholding taxes (W-2)
o Excess Social Security paid
o Long-Term Unused Minimum Tax Credit: unused minimum tax credits at least 3 years old may recoup
greater of: $5,000 or 20% of unused amount per year

Child Care Credit: Tax credit of 20% - 35% of eligible expenditures


- One dependent: $3,000 Two or more dependents: $6,000
- Must be qualified for child under age 13, any age disabled dependent, or disabled spouse
- Use LOWEST of: 1) earned income of the spouse with the lesser amount, 2) actual childcare expenditure, or 3)
maximum amount (i.e.$3,000 or $6,000 for 2008). The lowest amount would then be multiplied by applicable
percentage to get amount of the credit
- Eligible expenditures must be for enabling taxpayer to be gainfully employed:
o Babysitter
o Nursery school
o Day care
o NOT grammar school
- Maximum credit is 35% if income is $15,000 or less
- Phase out 20% - 35%: credit decreases by 1% FOR EACH $2,000 OF AGI over $15,000, but not below 20%
- Minimum credit is 20%: with AGI of more than 43,000 = $600 (20% of $3,000) or $1,200 (20% of $6,000)

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Credit for Elderly or Permanently Disabled: credit of 15% of eligible income
- For people at least 65 years old OR under 65 but retired due to permanent disability
- Base amount: $5k for S, $5k for MFJ w/1 spouse qualify, $7,500 MFJ w/2 spouse qualify, $3,750 MFS
- Eligible income is reduced by social security payments and other pensions AND reduced by ½ of AGI that
exceeds the following levels:
o S: $7500 MFJ: $10,000 MFS: $5000

Education Tax Incentives:


- Hope Scholarship Credit - $1800 maximum in 2008
o Qualified tuition and related expenses paid for student’s first two years of college  multiple kids OK
o 100% of first $1200 and 50% of next $1200
o Phase-out = MAGI exceeds $48000 ($96000 joint) with full phase-out at $58000 ($116000 joint)
- Lifetime Learning Credit - $2000 maximum per year
o Unlimited # of years for tuition (not books)
o 20% of expenses up to $10000
o Only 1 credit per year even if multiple kids
o Phase-out = MAGI exceeds $48000 ($96000 joint) with full phase-out at $58000 ($116000 joint)
- Coverdell Education Savings Account Distributions
o Can use in conjunction with Hope or Lifetime credit
o Cannot be used for same educational expenses for which either Hope or Lifetime was claimed
- Hope and Lifetime credits  using both in same year is OK

Qualified Tuition Programs (QTP):


- Exempt from all federal income taxation
- Making contributions to state qualified college savings plan
- Include room and board if enrolled at least half-time

MUST review chart on page R2-39  2008 Education Tax Incentives Summary

Adoption Credit:
- Credit for qualifying expenses of adopting a child is available:
o Per child: $11,650
o Special needs child: $11,650
- Phase-out = MAGI $174,730 - $214,730
- All reasonable and necessary expenses, costs, and fees are available for credit
- Medical expenses do NOT qualify
- Claim for years after payment is made until the adoption is final

Retirement Savings Contributions Credit: For the poor!


- Non-refundable tax credit that may offset both regular and alternative minimum tax is available for contributions to
either a traditional IRA or Roth IRA
- Must be 18 years old
- Not a full-time student
- Not a dependent

Foreign Tax Credit:


- LESSER of:
o Foreign taxes paid OR
o Taxable income from all foreign operations x U.S. Tax = Foreign tax credit limit
Taxable income + Exemptions
- Excess carry forward 10 years and carry backward 1 year

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General Business Credit: included combination of:
- Investment credit, work opportunity credit, alcohol fuels credit, increased research credit, low-income housing
credit, qualified childcare expenditures, welfare-to-work credit, employer-provided childcare credit
- Net income tax less the greater of:
o 25% of regular tax liability above $25,000 OR
o OR “tentative minimum tax” for the year
- “net Income Tax” = regular tax + alternative minimum tax less non-refundable tax credits
- Excess carry forward 20 years and carry-back 1 year

Work Opportunity Credit:


- Employers who hire employees from the following group:
o Handicapped
o 18-24 year olds from poor families
o Vietnam veterans from economically disadvantaged areas
o Certain food stamp recipients
- Credit: 40% if first $6,000 of first year’s wages

“Child” Tax Credit:


- Taxpayers may claim a $1,000 tax credit for each “Qualifying Child”
- “CARES” rules apply, except child must be under 17
- Phase-out begins: $110,000 MFJ, $55,000 MFS, $75,000 single
- Refundable to the extent of the LESSER of:
o Excess child tax credit (over tax liability)
o Earned income less $12,050 times 15%

Earned Income Credit  Refundable

Withholding Tax: Paycheck Credit


- When credit exceeds the tax liability, refund is generated

Excess FICA: Social Security Tax Withheld


- If you switch employers in middle of the year, you may pay additional FICA than required, the excess paid is a
credit against income tax

Individual Taxation – Other Taxes


Alternative Minimum Tax:
- Ensures that taxpayers who take a large number of deductions pay a minimum amount of tax on their income
- Pay in addition to regular tax

Regular Taxable Income


+- Adjustments
+ Preferences

Alternative Minimum Taxable Income


<Exemption>

Alternative Minimum Tax Base


x Tax Computation

Tentative AMT Tax


<Tax Credits>

Tentative Minimum Tax

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<Regular Income Tax>

Alternative Minimum Tax

Exemption Amounts:
- Exemption amount is:
o $33,750 less 25% (AMTI - $112,500) for single
o $45,000 less 25% (AMTI - $150,000) for joint filers
o $22,500 less 25% (AMTI - $75,000) for married filing separately

“Joint”
Exemption $45,000

AMTI
<$150,000>
Excess
X 25% .

<Reduction> .
AMT Exemption

Adjustments: Timing differences that may increase or decrease AMTI: PANIC TIMME
1. P – Passive activity losses
2. A – Accelerated depreciation (post 1986 purchase)
3. N – Net operating loss of the individual taxpayer
4. I – Installment income of a dealer
5. C – Contracts – percentage completion vs. Completed contract
Itemized deductions – always add back to regular taxable income
6. T – Tax “deductions”
7. I – Interest deductions on some home “equity loans”
8. M – Medical deductions (limited to excess over 10% AGI)
9. M – Miscellaneous deductions not allowed
10. E – Exemptions (personal) and standard deduction

Tax Preference Items – Always add backs - PPP


1. P – Private activity bond interest income
2. P – Percentage depletion the excess over adjusted basis of property
3. P – Pre 1987 accelerated depreciation

Credit for Prior Year Minimum Tax (AMT Credit): Certain allowable AMT paid in a taxable year may be carried forward
indefinitely as a credit. It may only reduce regular tax, not future alternative minimum tax.

Itemized deductions – always as add backs to regular table income:


- T - Taxes reduced by taxable refunds are added back
- I - Interest
o Investment interest must be recalculated
o Mortgage interest not used to buy, build, or improve home is added back
 Home mortgage is OK, and not added back
- M - Medical expenses must exceed 10% of AGI rather than 7.5%
- M - Miscellaneous deductions subject to the 2% floor are not allowed – they are added back
- E - Exemptions – personal and standard deductions may not be claimed

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Tax Preference Items – always “adds” to regular taxable income
- P – Private activity bond tax-exempt interest
- P – Pre 1987 accelerated depreciation on real property and leased personal property
- P – Percentage depletion deduction – excess over adjusted basis of property

AMT Credits – following credits are permitted as credit to reduce the AMT
- Foreign tax credit
- Adoption credit
- Child tax credit
- Contributions to retirement plans credit
- Earned income credit

Individual Taxation – Other Items

Statute of Limitations
- Statutory period during which the government can assess an additional tax
- Generally, 3 years from later of:
o Due date of return OR
o Date return is filed (included amended returns)
- If 25% understatement of gross income, 6 years from later of:
o Due date of return OR
o Date return is filed
- Fraud and false returns – no statute of limitations!

Refunds  Form 1040X


- Statutory period during which the taxpayer can claim and receive a refund
- Refund claim – later of:
o 3 years later from the date the return was filed or original due date of return OR
o 2 years from the time the tax was paid (if no return filed)
- Bad debts, worthless securities = bad luck = 7 years from later of:
o Due date of retrn OR
o Date return is filed

Tax payments include:


- Taxes withheld from paychecks (W-2 or 1099)
- Estimated taxes paid
- Excess Social Security tax withheld

A taxpayer is required to make estimated quarterly tax payments if both of the following conditions are met:
1. $1,000 or more of tax liability owed
2. Inadequete estimated payments – taxpayer’s withholding is less than the LESSER of:
a. 90% of current year’s tax OR
b. 100% of last year’s tax
i. Applies even if an individual files a tax return with a zero tax liability in prior year
ii. Exception: for 2008, use 110% of the 2007 year’s tax liability when AGI is in excess of $150k MFJ

Failure to pay estimated taxes = penalty

Form 1040 – Individual taxable income


Schedule A – Itemized deductions
Schedule B – Interest and dividend income
Schedule C – Profit or loss from business
Schedule D – Capital gains and losses
Schedule E – Supplemental income or loss (where partners from partnership report income and losses)

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I received the following post from someone on a different website, so for those of you reading this wanting clarification, I
found this very helpful:

Deductible IRA:
-Tax deductible now
-Grows tax free (deferred)
-Get taxed when you withdraw at retirement

Roth IRA (does not impact your taxes):


-NOT deductible now
-Grows tax free
-DOES NOT get taxed when you withdraw at retirement

Non-Deductible
-NOT deductible now
-Grows tax free (deferred)
-When you withdraw, you get taxed on your earnings only. You do not get taxed on what you put in originally since it was
already taxed back then.

(non-deductible pretty much sucks, but the other two have pretty low contribution limits. Think of non-deductible IRA as a
retirement plan for rich people only)

Deductions for contributions to traditional or Roth are limited to $5,000 (or the person's compensation, if it's less than
$5,000). If you are greater than 50 yrs old, deduct an extra $1,000.

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